Emerging Markets: Was It All ´Nirvana´?

Several Project Syndicate authors have recently declared the end of the emerging market miracle. One example among others (Hausmann) is a former finance minister of Chile, Andres Velasco who recalls the former Yale development economist Carlos Diaz-Alejandro. The latter used to say that the combination of high commodity prices, low world interest rates, and abundant international liquidity would amount to economic nirvana for developing countries.

Indeed, many emerging markets submerged in 2013: Genius ecopainter Benn Steil (Council on Foreign Relations, CFR) coined the term Emerging Markets Taperitis in his highly recommendable CFR Geo-Graphics (28-10-2013). The currency, stock and bond price reaction to a cautious statement by Fed Chairman Ben Bernanke (22-3-2013) in some emerging markets had been swift. But the pain was not shared equally. As the top figure in the CFR Geo-Graphic shows, those countries hit hardest by taper-talk were those with large current-account deficits—Turkey, India, Indonesia, and Brazil. They were also large beneficiaries of ´taper-talk interruptus´ mid-September 2013, when the fed backed away from the March taper talk. These events clearly indicate that holding down portfolio inflows and imports is what emerging countries need. Mainstream advice against capital inflow controls, reiterated by the OECD´s Adrian Blundell-Wignall in the face of fresh evidence, remains irresponsible propaganda.   

The convergence process in favour of emerging countries has not only been based on monetary factors, however. As has been documented (here; and here; and also here) on this blog, it has been closely linked with China´s long rise[1]. While Hausmann and Velasco focus on Latin America, the lasting benefits of China´s rise have been obtained by Asian countries embedded in an increasingly China centric manufacturing value chain[2]. Have a look at the numbers from the OECD Latin American Economic Outlook 2014 (courtesy The Economist) to see where and where not there has been fundamental catch-up in terms of total factor productivity in Asia (yes) and Latin America (no). So the Hausmann-Velasco perspective boils down to Latin navel-gazing.

As for the future, much will depend on China´s future growth path. In a paper forthcoming at the Annual Economic Review in 2014[3], Storesletten and Zilibotti deal with the commonly held Acemoglu-Robinson view that China’s growth trajectory is unsustainable, in particular due to the persistence of a non-democratic institutional framework so that it would not escape an institution-driven middle-income trap.  The Acemoglu-Robinson view, to be sure, ignores the fact that non-democratic institutions can adapt under contestability.

China’s experience attests to the potency of experimentation in bringing about transformative change, even in a rigid authoritarian, bureaucratic environment, and regardless of strong political opposition. Though the impact of reform experiments varies between policy domains, China’s experimentation-based policy process has been essential to redefining basic policy parameters (Sebastian Heilmann, 2008)[4]. Empirical support for the thesis has been provided by Besley and Kudamatsu (2007)[5] who find that economic growth rates differ more substantially among autocracies than among democracies. This is illustrated in the Figure below which depicts the distribution of growth performance in autocracies and democracies that survive for five years or more.  Successful autocracies outperform democracies at the top of the distribution. The prerequisite: political institutions make political leaders accountable, or make their survival in office depend on their policy performance. This may explain the long rise of China as well as the survival of China´s politbureau.

The recent decisions of the Third Plenary Session of the 18th CPC Central Committee seem to have identified crucial reform policies that will feed growth going forward. Urbanization and financial reform will help further exploit productivity gains embedded in China´s rural-urban and firm-size duality. Easing finance constraints for SMEs will advance de facto privatization and shift resources to entrepreneurial firms obviating the need for part of corporate savings. Reforming land rights will help farmers through improved property rights and lower corruption. Household savings will come down as a result of loosening the decades-long one-child policy. There is still life in China´s convergence; do not bet on its imminent collapse. And as long as China flourishes, so will most emerging countries.

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[1] In GIGA Focus Global 09/2013, I deal with China´s past and future rise at length (in German).

[2] Also African manufacturing starts to benefit via special economic zones, foreign direct investment, infrastructure and low-cost capital goods.

[3] Storesletten, Kjetil, und Fabrizio Zilibotti (2014), “China´s Great Convergence and Beyond”, Oslo/

Zürich, mimeo, Annual Economic Review.

[4] Heilmann, Sebastian (2008), “Policy Experimentation in China´s Economic Rise”, in: Studies in Comparative International Development, 43, 1, 1-26.

[5] Besley, Timothy, und Masayuki Kudamatsu (2007), “Making Autocracy Work”, CEPR Discussion Papers, 6371, London: Centre for Economic Policy Research.

The Chinese Puzzle: Democratic Transition, Authoritarian Resilience, or Chaotic Breakdown?

Berlin is getting richer, and not necessarily less sexy. At least not if you are interested in smart debates on international economics and diplomacy. Think tanks keep popping up like mushrooms in these wet autumn days. The Stiftung Mercator is just now establishing the Mercator Private Institute for China Studies (MERICS), which will be directed by the political scientist and China expert Prof Sebastian Heilmann. Among other activities, Heilmann has been researching Adaptive Authoritarianism, a term which describes the performance of China´s Politbureau over the past 30 years pretty well.

At MERICS, I attended (with GDN´s Pierre Jacquet who happened to be in Berlin) a rich and dense meeting, dubbed the Berlin China Dispute that discussed the political (and hence economic) future of China´s political regime. Thomas Bagger, Minister Cabinet Head of the German Foreign Affairs, did a great job of moderating the dispute (yes, it does show when the moderator has a full grasp on what is to be debated!). The high-calibre Mercator event brought together three renowned international experts on China's political development who represented diverse and conflicting positions in the controversy about China's future political trajectory: Andrew J. Nathan, Professor of Political Science, Columbia University, and American Academy, Berlin; Minxin Pei, Director of the Keck Center for International and Strategic Studies, Claremont McKenna College; and Sebastian Heilmann.

During the past three decades, China's political system has managed to outlast most other variants of Communist Party rule and has overseen the fastest economic expansion in world history - a transformation that has brought with it not only greater wealth and global clout, but also growing income and regional inequality, severe ecological degradation, frequent popular protest and recently intensifying political-ideological contestation. What kind of political transformation will China's massive economic, social and technological transformation bring about in the near future?

Sebastian Heilmann started the opening salvo: It is not China that has collapsed – rather the China doom scenarios have collapsed (sic!). Unlike other authoritarian regimes, China has succeeded in pushing back interest groups, according to him. China has taken the Marxist approach: economic reform first, political reform follows. Just like Bert Brecht wrote in 1928 to Kurt Weill´s music in the Dreigroschenoper : "Erst kommt das Fressen, dann kommt die Moral." - Denn wovon lebt der Mensch?  (Food is the first thing, morals follow on. – What keeps manhood alive?). As China engineers its economy increasingly toward consumption, her external clout and leverage is bound to rise on the global scale – not least through higher merchandise and service imports.

Andrew Nathan tried to occupy the middle ground. He viewed China as a case of resilient authoritarianism and pointed in the list of explanations (which curiously missed out on the more than half billion people that have been released from extreme poverty over the last 30 years) to an effective repression apparatus. Nathan emphasized that the event of any breakdown of one-party rule in China had a nonlinear probability and would be potentially chaotic and disastrous. Nathan, however, also pointed to some interesting, underemphasized side effects of the sprawling media, in particular the social media, that are commonly merely (mis)perceived as a threat to the one-party rule. A proactive government, he argued, can also well use them for piecemeal reform as it is rapidly informed about public anger. By accommodating complaints popular in the social media, they can in principle be used by the rulers for authoritarian resilience - rather than lead to the erosion of political power.

Exiled Chinese academics based in the US often are among the sharpest regime critics; Yasheng Huang comes to mind[1] . So is the highly articulate Minxin Pei. According to him, the breakdown of the one-party regime is a high-probability event in the next ten year resulting of the following trends:

·         the narrowing of the social base underpinning the party (ever more ruled by ´bureaucrats´);

·         quantitative indicators of regime breakdown probability, especially China´s current and future per capita income level;  so China now belongs to a country group where ´democracy´ is the norm as only 29 ´non-democracies´ (half of them oil-rich) remain that are richer than China according to Freedom House classification;

·         average survival length of one-party rule is 70 years (with the Kuomintang's defeat, Mao Zedong established the People's Republic of China under CPC (Communist Party of China) rule on October 1, 1949);

·         and the population´s growing exclusion (in relative terms) from higher education.

What could trigger a regime breakdown? Prime candidate is financial liberalization which is feared to result in cascading, uncontrollable balance-sheet disruptions. It remains to be seen whether special zones such as Shanghai can experiment gradual reform in finance as it is hard to see how they can remain isolated from the rest of mainland China.

Pierre Jacquet[2] asked the panelists whether they believed in a teleological orientation of history, referring to the book Violence and Social Orders by North, Wallis and Weingast (Cambridge U Press, 2009).  The authors had defined development as the transition from a closed access social order in which the economy is closed and a small elite captures and redistributes rents to an open access social order; the latter being characterized by openness and competition in the economic realm and contestability through elections in the political realm in which the direction unambiguously goes toward competition both on the economic and political realms because both have to go together. Such Fukuyama-style end-of-history view is very relevant to the discussion of any Chinese "puzzle", and, with the exception of Heilmann, the others confirmed that they believed in this teleological vision. The difference between them was more a question about how the transition takes place: crisis for Pei, control and slow and delayed adjustment for Nathan; by contrast, learned agnosticism for Heilmann as we just don't know the direction that China will take while new models may emerge on the way.

Once again, there is no end of history. And I left the Berlin China Dispute with the suspicion nagging even deeper that political sciences, not economics, may be the queen of social sciences…

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[1] See his recent Ted blog entry Why democracy still wins: A critique of Eric X. Li’s “A tale of two political systems”. I guess that anti-China views ´pay´ better in the US both than elsewhere and than do pro-China views.

[2] Special thanks to Pierre for having clarified that part oft he debate to me.

Is the Asian Market Slump Due to China´s Monetary Policy?

The prospect of the ebbing of easy liquidity has exposed many emerging market economies’ vulnerabilities this summer, with India and Indonesia as epicenters of recent currency, stock and bond market losses in Asia. Despite ongoing sharp correction in the asset markets of those countries, the short-term pain may not be over yet: When it rains, it pours in emerging markets. With foreign flows becoming scarce, inevitable and painful current account adjustment is underway, with interest rates rising, consumption and imports falling, and GDP growth rate decelerating.

 

Usually, the current travails in emerging markets are blamed on expectations of slowing open market purchases by the US Federal Reserve System. Lars Christensen, head of emerging market research at Danske Bank, however, blames China´s monetary tightening as at least as important as the expected US Fed ´tapering´.  I have myself, with former colleagues, pointed to the growing impact that China´s growth has exerted since the last decade on GDP growth in middle- and low-income countries[1], pointing to the growing raw material, trade and production links of increasingly China centric emerging countries. So I shall have a lot of sympathy for Lars Christensen´s earlier proposition that China has also grown into a monetary superpower in a Sino monetary transmission mechanism with the rest of Asia. China´s monetary tightening, however, can hardly explain the current slump in Asian markets, on closer inspection.

Graph 1: US 10y Treasuries, Futures

Source: finanztreff.de, 20/08/2013

 

First, let us consider  the expected monetary stance in the US and in China. Graph 1 clearly shows that the market has formed expectations since May that the Fed would not continue open market purchases at the pace witnessed over the last years, partly fueled by Bernanke´s taper talk that month to US Congress. China´s monetary tightening, by contrast, occurred during late 2010 to early 2012 from when the Bank of China started to ease again[2]. Since then, minimum reserve requirements were repeatedly reduced. Further, the PBC reduced its benchmark deposit and loan rates in June 2012. In addition, the PBC has also used a mix of monetary policy instruments to appropriately increase market liquidity. Between Q1 2012 and Q2 2013, China´s M1 aggregates rose by more than 13%. Even considering huge time lags, the current turmoil of Asia stock and bond markets cannot be blamed on China´s monetary tightening prior to end 2011. Nor can the current drop in raw material prices, which is also related to rising bond yields in the US.

 

Second, both emerging bond markets (Graph 2) and equity outflows (Graph 3) from the emerging market space (to which China belongs) back to the safe heaven developed markets display a very close connection to the US 10y Treasuries futures prices displayed above in Graph 1. Virtually no time lag seems involved, confirming the validity of the 1990s literature on push (v pull) factors which had emphasized the importance of US interest rates for emerging-market flows[3].

 

 

Graph 2: SPDR Barclays Capital Emerging Market Local Bond ETF

Source: finanztreff.de, 20/08/2013

 

Graph 3: Net Flows EM Equity Funds, 2013

Source: ft.com, 20/08/2013

 

End of story. But let´s go on, for the sake of learning.

 

Third, monetary transmission from China to Asian markets would imply, as correctly emphasized by Christensen, some sort of renminbi peg by the affected countries. Indeed, the ever closer integration of global value chains in Asia, with China replacing Japan as the major hub,  arguably creates  (and partly justifies) “Fear of Floating” more than anywhere else in the world. But closer inspection of the recent literature on effective (as opposed to merely proclaimed) currency regimes in Asia reveals that the two countries most affected by the current slump – India and Indonesia – did mostly not show a strong weight of the renminbi in their effective (trade weighted) exchange rates. Randall Henning[4] finds that during 2010-11 the Indonesian rupiah was strongly pegged to the US dollar. As for India, Cavoli and Rajan[5] find evidence of moving from a quasi-peg to the US dollar to more flexibility over recent years.

 

Cheap advice to the Asian victims of US monetary policy comes easy – from abroad. Most observers today recommend that the countries float (rather than impose outflow controls). This advice ignores the growing production and trade integration within Asia. It also ignores that those who suffer most these days were found to run the most flexible currency regimes among Asian peers.

 

To link Asia´s current asset market slump to China´s monetary stance is a red herring, perhaps an attempt to deflect responsibility from the US Fed for cyclical in- and outflows into emerging markets and return the blame to China. (In a way, a variation ofthe disapproved Bernanke hypothesis that the Asian saving glut caused globalimbalances in the past.)

 

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[1] “The Renminbi and Poor-Country Growth”, The World Economy, Vol. 35, 2012.

[2] Wang Yu, The adjustment of China´s monetary stance in the face of global liquidity, BIS Papers No. 70.

[3] See, e.g., Eduardo Fernandez-Arias, „The new wave of private capital inflows: Push or pull?”, Journal of Development Economics, Volume 48, 1996.

[4] C. Randall Henning (2012), „Choice and Coercion in East Asian Exchange Rate Regimes”, Peterson International Institute Working Paper 12-15.

[5] T. Cavoli and R.S. Rajan (2013), „South Asian Exchange Rate Regimes: Fixed, Flexible or Something In-between?”, South Asia Economic Journal, Vol. 14, 2013.

Germany´s Next Aid Model

No, this is not about Heidi Klum. God forbid! Neither it is about the German deputy development minister Gudrun Kopp (see picture for blond hair).

Just seven weeks ahead of Germany´s national election, it is time to think about how German development cooperation should be conceptualised in the forthcoming government. Five years ago, William Easterly and Tobias Putze tried to get a handle at an ´ideal´ aid agency strictly based on empirically observable parameters[1] (rather than negotiated and vetted DAC peer reviews). Their study, covering 38 bilateral and several multilateral aid agencies, was based on criteria derived from the bulging development aid literature:

·         Transparency (a precondition necessary for any meaningful evaluation)

·         Specialisation (avoiding fragmentation of aid supplies costly to recipients)

·         Selectivity (focus on poor countries)

·         Efficient delivery (avoiding tied aid, food aid, and technical assistance)

·         Administrative loss (share of aid bureaucracy cost).

Among the bilateral aid agencies covered in the Easterly/Putze study, Germany´s BMZ occupied the second last rank! German cooperation was seen in particular as fragmented, bureaucratic and nontransparent compared to its DAC peers.

 

Meanwhile, the recalibration of the world economy toward China and the success of large emerging countries in helping lower global poverty (aka Shifting Wealth) have turned some of the cited criteria for evaluating aid agencies doubtful, even obsolete. Shifting Wealth, apart from allowing for a milder assessment of past and present BMZ performance than granted by the Easterly/Putze study, suggests some specific recommendations for Germany´s aid over the next legislation period (2013-17) that actually can be opposite to some of the traditional criteria:

·         The selective focus of aid needs to shift from poor countries to poor people. Only just two decades ago, 93 percent of the world´s poorest people lived indeed in the poorest (least developed) countries; today, three fourth of the world´s poorest people survive in countries now classified as middle-income countries (Ravi Kanbur und Andy Sumner, 2011)[2]. For humanitarian reasons, the aid focus needs to reflect the new geography of poverty, even against populist sentiment at home. In India, half a billion people remain in abject poverty, 200 million in China. Other countries that the BMZ should focus on, according to the selectivity criterion ´number of poor people´, are Nigeria, Bangladesh and Indonesia.

·         The implicit reorientation of development cooperation from Africa to Asia would also change the optimal mix of aid finance, from grants toward soft loans. Often cash rich, emerging countries´ poverty is their own prime responsibility. Western development loans, however, can lever political choices in those countries while they are less burdensome for fragile budgets in DAC countries, potentially more flexible and delivered more speedily (at least if they follow the innovative  Agence Franaise de Développement model) conceived by Cohen, Jacquet and Reisen (2006)[3].

·         China´s and other emerging countries´ proven contribution to global development and poverty reduction, notably in Africa (African Economic Outlook 2011), is forcing Western donors to reexamine their standards and to find ways to merge them with Eastern cooperation modes. The merger of Western standards, which is heavy on declamatory good-governance rhetoric, with project-oriented Eastern cooperation modes, often nontransparent as based on barter deals, is yet to be designed, it seems to me.

·         German bilateral cooperation excels on implementation – and should ´sell´ itself so. Unlike Britain (remember Tony Blair?) and France, Germany has relatively few spin doctors. But it has GIZ (the project implementation agency) and KfW (the development bank). These institutions grant Germany a comparative advantage in project delivery and completion. Germany´s bilateral cooperation is thus defined by close links with programmes and projects, creating high visibility for many German actors and facilitating their financial monitoring. These traits of German cooperation, largely undersold to DAC peers and multilaterals, make it a valuable partner for trilateral South-South-North cooperation, in particular joint with China.

·         Help restore core finance for multilateral development cooperation. Where -unlike in Germany - implementation agencies are lacking, there is a tendency to use multilaterals via earmarked funding. Germany has largely refrained from multilateral ´cherry-picking´ and should work hard on its peers to stop this trend, which has weakened the UN system ever since the US called to call the shots there, i.e. since the 1960s when many countries became sovereigns independent from colonial rule. A high share of earmarked finance in multilateral budgets causes permanent ´funds shopping´ by management, thus diverting its attention and time; it raises administrative overhead costs; and it intensifies the bureaucratic tendency for mission creep and fight for mandates. The unproductive struggle among multilaterals for G20 mandates provides a visible warning. Germany´s next government is called for to clean the multilateral donor chaos; due to tutelage problems, this task can´t be let to ministries – the Bundeskanzleramt will have to deal with the problem[4].

It is questionable whether the current BMZ ministry can confront these challenges in its current setup[5]. Where most of the extremely poor people reside today, namely in large emerging countries, development cooperation can only succeed by managing cross-cutting issues, integrating policy fields as diverse as food security, basic welfare systems and green urbanisation.

 

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[1] Easterly, W. und T. Putze (2008), “Where Does the Money Go? Best and Worse Practices in Foreign Aid”, Journal of Economic Perspectives, Vol.22.2, S. 29-52.

[2] Kanbur, R. und A. Sumner (2011), “Poor Countries or Poor People? Development Assistance and the New Geography of Global Poverty”, Cornell University, WP 2011-08.

[3] Cohen, D., P. Jacquet and H. Reisen (2006), “After Gleneagles: What Role for Loans in ODA?”, OECD Development Centre Policy Brief No.31.

[4] H. Reisen (2012), “Herausforderungen an die multilaterale Entwicklungszusammenarbeit“, KfW Meinungsforum Entwicklungspolitik, Nr.4, 4.April 2012.

[5] J. Faust und D. Messner (2012), “Probleme globaler Entwicklung und die ministerielle Organisation der Entwicklungspolitik“, Zeitschrift für Außen- und Sicherheitspolitik“, Vol. 5, S. 165-175.

Exit, Voice and Loyalty in Dual Economies

* A similar entry will be posted today on the OECD Insights blog. I wish all readers a nice summer break. HR

The recalibration of the world economy toward the emerging countries, mostly a result of superior prolonged growth in the Asian giants China and India, has since 1999 helped move roughly half a billion people above 2$ a day, the median income poverty threshold in developing countries. Homi Kharas´ estimates for the OECD Development Centre[1] projected almost 70% of the world´s middle class consumption – 56$ trillion by 2030 - to be outside the OECD. No wonder then that the term ´emerging country middle class´ has been driving big dollar signs into many eyes.

Yet, the urban middle class youth is revolting in Brazil, Turkey and other fast growing countries. The controversy around the Easterlin Paradox, a key concept of happiness economics, suggests that happiness grows more slowly than incomes. Leaders in many emerging countries are today confronted with a dilemma that reflects the dual rural-urban structure of their large societies. While the internet savvy young urban middle class has left poverty behind and demands voice, participation and efficient public services, there still coexist the poor in the rural hinterland striving to leave individual poverty behind.  

 

Exit, voice and loyalty, the late Albert O Hirschman´s intriguing basic categories that drive societal change, can be used to better understand the current conundrum. Loyalty, through adherence to a political unity party or to religion, can block change but is waning. Exit and voice have different potential in a rural-urban context: exit from the rural to the urban sector is a preferred option for the rural poor but is mostly a one-way street; whence voice as the preferred option for the urban middle class.

Much of the emerging-country middle class is fragile. Lousy education, poor health and urban congestion are the biggest risks to the lower strata of the middle class, by way of social and economic exclusion. A higher size of middle-class citizens translates into higher prices for private schools, hospitals and transports or, alternatively, overcrowding. The private provision of quality public services is a socially dividing, hence limited, costly option. In other words, exit to private education and health services - an option for the ´happy few´ - will raise prices to the point that it triggers voice while the size of the middle class rises.

“First-world soccer stadiums; third-world schools and hospitals”, was one of the slogans advanced by Brazil´s protesters; Brazil has already spent more than 3bn$, three times South Africa’s total four years earlier, and only half the World Cup stadiums are finished. Public health spending occupies a mere 4 per cent of GDP in Brazil (despite constitutional declaration for universal health care rights), compared to 6 in Turkey and 7 in OECD average. For Mathematics, the latest PISA test scores rank Brazil 57^th out of 65 survey countries, Turkey is ranked 43^rd. These numbers suggest that there is a political and social premium on best practices in the governance and allocation of public spending of tax receipts. Apparently, that premium has not been reached.

Emerging-country leaders might ignore the insights of the OECD Latin American Outlook 2011 at their own peril[2]. The policy recommendations put forth there rightly emphasize the need for ´fiscal legitimacy´. To avoid the emerging middle class blues, public finances need to strengthen the social contract, provide better opportunities for the vulnerable people and better quality public services. Middle-income citizens are more willing to pay taxes for services, such as transport, health care and education, if they perceive them to be of high quality and if ´white elephants´ - trophy public investments with little social value – are avoided.

It is quite likely that the current protests, while destabilizing and weakening the affected governments in the short term, will be the start to stronger democracies and strengthen, rather than weaken, the rise of the emerging countries. Already Aristotle[3] reflected “that the best political community is formed by citizens of the middle class, and that those states are likely to be well-administered in which the middle class is large […]; for the addition of the middle class turns the scale, and prevents either of the extremes from being dominant.”

 

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[1] Kharas, Homi (2010), „The Emerging Middle Class in Developing Countries“, OECD Development Centre Working Paper No. 285.

[2] OECD (2011), Latin American Economic Outlook 2011: How Middle-Class Is Latin America?, OECD Publishing. http://dx.doi.org/leo-2011-en.

 

[3] Vogt, Susanna (2011), “Globalisation from the Bottom Up: The Aspiring Middle Classes in Emerging Economies”, KAS International Reports 12|2011, Berlin: Konrad-Adenauer-Stiftung.